Increasing Returns and Path Dependence in the Economy

Foreword

Foreword Kenneth J. Arrow The concept of increasing returns has had a long but uneasy presence in economic analysis. The opening chapters of Adam Smith's Wealth ofNations put great emphasis on increasing returns to explain both specialization and economic growth. Yet the object of study moves quickly to a competitive system and a cost-of-production theory of value, which cannot be made rigorous except by assuming constant returns. The English school (David Ricardo, John Stuart Mill) followed the competitive assumptions and quietly dropped Smith's boldly-stated proposition that, "the division of labor is limited by the extent of the market," division of labor having been shown to lead to increased productivity. Other analysts in different traditions, especially the French mathematician and economist, A. A. Cournot (1838), saw clearly enough the incompatibility of increasing returns and perfect competition and developed theories of monopoly and oligopoly to explain the economic system implied by increasing returns. But this tradition acts like an underground river, springing to the surface only every few decades. Alfred Marshall expanded broadly, if vaguely, on the implications of increasing returns, including those for economic growth, irreversible supply curves, and the like, as well as the novel and far-reaching concept of externalities, where some, at least, of the increasing returns are captured, not by the producer but by others. The implications of increasing returns for imperfect competition were developed, though far from completely, by Edward Chamberlin and Joan Robinson in the 1930s. There was sporadic emphasis on the role of increasing returns in economic growth by Allyn Young (1928) (but only in very general terms) and then by Nicholas Kaldor in the 1950s. Many developmental theorists , particularly in the 1950s, advocated radical planning policies based on vague notions of increasing returns. It is in this context that Brian Arthur's precise and fully-modeled papers caused us all to understand clearly and specifically what kinds of models have what kinds of implications. One outstanding characteristic of Arthur's viewpoint is its emphatically dynamic nature. Learning by using or doing plays an x Foreword essential role, as opposed to static examples of returns to scale (e.g., those based on volume-area relations). The object of study is a history. Another distinctive feature of most of the work is its stochastic character. This permits emphasis on the importance of random deviations for long-run tendencies. In particular, nonlinear Polya processes, studied by Arthur and his probabilistic colleagues, have very interesting properties. Among them are several essential implications of Arthur's viewpoint, in particular the multiplicity of possible long-run states, depending on initial conditions and on random fluctuations over time, and the specialization (in terms of process or geographical location) in an outcome achieved. Increasing returns have more than one source. Arthur (in collaboration with David Lane) shows how the transmission of information based on experience may serve also as a reinforcement for early leading positions and so act in a manner parallel to more standard forms of increasing returns. A similar phenomenon occurs even in individual learning, where again successes reinforce some courses of action and inhibit others, thereby causing the first to be sampled more intensively, and so forth. There are in all of these models opposing tendencies, some toward achieving an optimum, some toward locking in on inefficient forms of behavior. It is clear that Arthur's papers, collected in this volume, are an important part of the modem movement toward using positive feedback mechanisms to explain economic growth. Arthur's views are indeed more nuanced; they show how the same mechanisms can lead to inefficiency under suitable initial conditions or random fluctuations, and so they provide a necessary corrective to some overly optimistic current tendencies in thought. Arthur's papers, while modeled according to the highest analytic standards , sometimes look different from standard economic analysis, and that is a compliment. Expectations are frequently myopic, based on limited information . Prices, though always present, are not always given the exaggerated importance of much current economic orthodoxy, though it must be added there is an excellent analysis of their strategic use in positive feedback situations . I must emphasize the importance of these variant approaches, particularly in areas where conventional tools simply fail. It is a benefit to economists to have these papers from widely scattered sources brought together conveniently. The volume will be an important stimulus to new research in these areas. ...